I would like to use USD Index chart to paint a picture of how behaviour of market participants can ebb and flow. Most common feature is the herd behaviour (increasingly due to greater role of the retail traders) to overestimate news impact by following a base case scenario, tempering news to the contrary. Example: USD index rallied on anticipation of FED raising interest rate mid 2015 without much regard to how weakening data could affect that outlook. Also US yields were expected to rally further without taking into consideration that slowing economy will push money in to bonds.

Another feature is to give more weight to the contrary news than confirming (the trend) news at market extreme, e.g. Oct 3rd Dudley’s comments triggered a fall in USD Index as he indicated, just his own opinion, that Fed should have a very accommodative monetary policy. Market participants just didn’t consider that previous data points were relatively stable. When US advance retail sales numbers disappointed, market overweighed the news to trigger sharp drop as panic struck, at least in the short-term.

I think this behaviour is captured well in prices and therefore technical analysis advice on buying on dips and selling on pullbacks. There is also mileage to Contrarian’s view that correction is likely when markets go to extreme in the short-term, but this is risky to trade as market corrections are sometimes difficult to judge.

Rahul is an FX Strategist for the TraderMade Research team.Follow Rahul on Twitter to see his intra-day updates...Check out the TraderMade Research service...